The Retirement Savings Contribution Credit — Not the Bonanza that It Seems

As tax time approaches, various articles, on the web and in print publications, tout tips on how to save on taxes. One of these tips often mentioned is the retirement savings contribution credit. If you make a contribution to a traditional IRA, a Roth IRA, certain salary reduction contributions, or contributions to a section 501(c)(18) plan, you, supposedly, may be able to claim a credit for up to $1,000 for a $2,000 contribution, if your adjusted gross income is low enough. That sounds really nice! Put $2,000 into your IRA or Roth account and have the federal government pay for half of that.

However, the devil is in the details, specifically, in the way that the retirement savings contribution credit is calculated. On Form 8880, Credit for Qualified Retirement Savings Contributions, the form used to calculate the credit, you must take the amount on line 46 on Form 1040, which is the adjusted gross income minus the standard deduction and personal exemptions, then subtract the sum of any foreign tax credit, the credit for the elderly or disabled, the credit for child and dependent care expenses, and education tax credits. This will yield the maximum amount of the credit. However, because of the income limits for the retirement credit, subtracting the standard deduction and personal exemptions will yield a tax that is lower than the maximum credit, even if the sum of the above credits (lines 47-50) is zero. And because the amount of the tax is calculated before payroll taxes are added, the credit can't be used to offset any payroll taxes — it is a nonrefundable tax credit.

To illustrate, consider the following examples for the tax year of 2006:

  1. For a single person, the maximum amount of the adjusted gross income for which a 50% credit can be claimed is $15,000. Subtracting the standard deduction of $5,150 and the personal exemption of $3,300 yields $6,550, which yields a tax of $653. Thus, this is the most that a single person can claim. If the person makes even $1 more than $15,000, then the credit rate drops to 20%.
  2. A head of household can make as much as $22,500 and still claim the 50% credit. However, a head of household would have at least 2 personal exemptions, because to be a head of household, there must be at least 1 other dependent. So subtracting the $7,550 standard deduction for head of household and 2 personal exemptions worth $6,600 would yield a taxable income of $8,350, which yields a tax of $838 — still less than the theoretical maximum of $1,000. The credit becomes much less if the head of household has more dependents — it becomes zero if the number of dependents is 4 or more.
  3. A married couple filing jointly can earn up to $30,000 dollars total, and still qualify for a 50% rate that applies to each spouse. In other words, a married couple can theoretically claim a credit of $2,000 for a $4,000 contribution, but, again, the standard deduction and personal exemptions lowers the taxable amount to less than the credit. Subtracting the standard deduction for married couples filing jointly of $10,300 and the 2 $6,600 of personal exemptions that they could claim for themselves from the maximum adjusted gross income of $30,000 yields a taxable income of $13,100, which yields a tax of $1,313. So $1,313, not $2,000, is the maximum retirement savings contribution credit that can be claimed. If they have children, the credit becomes much less.

So the government isn't so generous after all!